Business Finance · Structure and methods of financing a company
Capital Structure and Gearing Explained for CB1
Updated 11 October 2026 · Fact-checked
Capital structure is the mix of debt and equity a company uses to fund itself. Gearing measures how much of that funding is debt. To solve questions, pick the stated definition, compute the ratio from the figures, then judge risk, cost and tax effects. Interest cover shows how easily profit pays interest.
Understand Capital Structure and Gearing
A company funds its assets with equity (ordinary shares and retained profits) and debt (loans, bonds, debentures). The proportion of each is its capital structure. Preference shares sit between the two. Whether you treat them as debt or equity depends on the question, so state your choice.
Gearing (financial leverage) describes how heavily a company relies on debt. Debt carries a fixed interest payment that must be paid whether or not profits are made. So higher gearing makes profits and returns to shareholders more volatile. In good years equity holders gain more. In bad years they lose more, and the risk of default rises.
There are two families of measures. Capital gearing ratios look at the balance sheet, comparing debt with equity or with total capital. Income gearing ratios, mainly interest cover, look at the profit and loss account and ask whether profit can service the interest.
Debt is usually cheaper than equity. Lenders have a prior claim on assets and income, so they accept a lower return. Interest is also normally deductible before tax, which creates a tax shield: each rupee of interest reduces tax by the tax rate times that rupee. Against this, more debt raises the risk of financial distress, and may bring covenants from lenders.
Choosing between debt and equity depends on several factors: the stability of cash flows, the amount of existing gearing, available security, tax position, cost of each source, control (new shares dilute owners), flexibility, market conditions and the lenders' covenants. Stable, asset-rich firms can carry more debt. Volatile, growth firms usually should not.
Key rules to remember
- Debt to equity ratio
- Debt ÷ Equity
- Equity means shareholders' funds (book value unless the question says market value). Debt is usually long-term borrowings.
- Gearing ratio (debt to capital)
- Debt ÷ (Debt + Equity)
- Also written as a percentage. Always state whether debt includes preference shares and short-term borrowings.
- Interest cover
- Profit before interest and tax (PBIT) ÷ Interest payable
- A higher figure means a safer position. It is a multiple, not a percentage.
- Tax shield on interest
- Tax shield = Interest × Tax rate
- Applies where interest is tax deductible and the company has enough taxable profit to use it.
- After-tax cost of debt
- Pre-tax cost of debt × (1 − tax rate)
- Use for WACC when interest is deductible.
- Return to equity under gearing
- Profit after interest and tax ÷ Equity
- Rises with gearing when return on assets exceeds the cost of debt, and falls when it does not.
How to solve Capital Structure and Gearing questions
Use this approach for ratio, comparison and discussion questions on capital structure.
- 1Read the question for the required definition of debt, equity and gearing. If none is given, state your own.
- 2List the figures needed: debt, equity, PBIT, interest, tax rate.
- 3Compute each ratio, showing the formula and the numbers.
- 4If tax is involved, compute interest × tax rate for the shield, or the after-tax cost of debt.
- 5Compare companies or scenarios, and say which is more risky and why.
- 6Link the result to the effect on shareholders: volatility of earnings, risk of default, dilution or control.
- 7Name the relevant factors for the financing choice, applying them to the company described.
- 8Finish with a clear conclusion that answers the exact question asked.
Quickest way: Ratio, risk, tax in three passes
When to use it: Use in multiple-choice questions and short written parts when time is tight.
- Write the three formulas you may need: debt ÷ equity, debt ÷ (debt + equity), PBIT ÷ interest.
- Plug in the numbers once, checking that debt and equity use the same basis.
- For tax questions, multiply interest by the tax rate and stop.
- Match the answer to the direction expected: more debt means higher gearing, lower cover and higher risk.
- Eliminate options that confuse a ratio with a percentage or swap numerator and denominator.
Common mistakes in Capital Structure and Gearing
Using debt ÷ equity when the question asks for debt ÷ (debt + equity).
Both are called gearing and the formulas look similar.
Fix: Write the definition first, then compute. Debt ÷ equity is always larger than debt ÷ capital.
Calculating interest cover with profit after interest.
Students take the last profit figure on the statement.
Fix: Use profit before interest and tax in the numerator unless told otherwise.
Applying the tax shield when the company makes losses.
Students apply the rule mechanically.
Fix: State that the shield only has value if there is taxable profit to set the interest against.
Saying higher gearing always raises shareholder returns.
One favourable example is over-generalised.
Fix: Say it raises returns only when the return on assets exceeds the cost of debt, and raises risk either way.
Mixing book and market values in one ratio.
Debt is given at book value and equity at market value, or the reverse.
Fix: Use consistent values and state which basis you used.
Listing factors for debt versus equity without applying them.
Students memorise a list.
Fix: Tie each factor to the company in the question, such as stable cash flows or lack of security.
Worked examples
Example 1
A company has long-term debt of ₹40,00,000 and shareholders' equity of ₹60,00,000. PBIT is ₹15,00,000 and interest is ₹4,00,000. The tax rate is 25%. Calculate debt to equity, debt to capital, interest cover and the annual tax shield.
Show the solution
- Debt to equity = 40,00,000 ÷ 60,00,000 = 0.667.
- Capital = 40,00,000 + 60,00,000 = ₹1,00,00,000.
- Debt to capital = 40,00,000 ÷ 1,00,00,000 = 40%.
- Interest cover = 15,00,000 ÷ 4,00,000 = 3.75 times.
- Tax shield = 4,00,000 × 25% = ₹1,00,000.
Answer: Debt to equity 0.667 (about 0.67), debt to capital 40%, interest cover 3.75 times, tax shield ₹1,00,000 a year.
Example 2
Company A and Company B each have total capital of ₹1,00,00,000 and PBIT of ₹12,00,000. A is all equity. B has ₹50,00,000 of debt at 8% and ₹50,00,000 of equity. Ignore tax. Compare the return on equity and comment on risk.
Show the solution
- Company A: no interest, so profit = ₹12,00,000.
- Return on equity for A = 12,00,000 ÷ 1,00,00,000 = 12%.
- Company B: interest = 50,00,000 × 8% = ₹4,00,000.
- Profit for B = 12,00,000 − 4,00,000 = ₹8,00,000.
- Return on equity for B = 8,00,000 ÷ 50,00,000 = 16%.
- Interest cover for B = 12,00,000 ÷ 4,00,000 = 3 times. A has no interest, so cover is not relevant.
- Return on assets of 12% exceeds the 8% cost of debt, so gearing raises the return to equity. If PBIT fell, B's return would fall faster and B could struggle to meet interest.
Answer: Return on equity is 12% for A and 16% for B. B's higher return comes with higher financial risk, shown by interest cover of 3 times.
Exam tips
- Always state your definition of gearing before calculating. Marks often depend on consistency.
- In written answers, give both the calculation and a sentence of interpretation.
- For choice of financing, tailor the factors to the company's cash flows, assets and tax position.
- Mention the tax shield together with its limits: it needs taxable profits, and distress costs offset the benefit.
- In multiple-choice questions, check direction first: more debt raises gearing and lowers interest cover.
Practice questions from Structure and methods of financing a company
- Rohan Ltd's shares are priced at ₹200 ex-dividend. The dividend just paid was ₹10 per share and dividends are expected to grow at 5% a year …
- Which feature of a bond issue is designed mainly to protect lenders by restricting the borrower's future actions, such as limits on further …
- A company has Rs 40 crore of equity and Rs 10 crore of long-term debt. Which of the following gives its debt-to-equity gearing ratio?
- Shree Textiles Ltd needs Rs 50 crore. Its profit after tax is Rs 40 crore and it normally pays out 60% as dividends. It has no spare cash. I…
- Which of the following is the most significant internal source of long-term finance for an established, profitable Indian manufacturing comp…
Capital Structure and Gearing in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Capital Structure and Gearing: frequently asked questions
What is the difference between gearing and interest cover?
Gearing is a balance sheet measure of how much debt a company uses compared with equity or total capital. Interest cover is a profit measure showing how many times profit before interest and tax covers the interest bill. You need both to judge risk.
Is high gearing always bad?
No. High gearing can raise returns to shareholders when assets earn more than the cost of debt, and debt gives a tax shield. It is risky because interest is fixed and must be paid, especially if profits are volatile.
How does the tax shield work?
Where interest is tax deductible, it reduces taxable profit. The tax saved equals interest multiplied by the tax rate. This is why the after-tax cost of debt is lower than the stated interest rate.
Which factors decide between debt and equity?
Key factors are cash flow stability, existing gearing, security available, tax position, relative cost, control and dilution, flexibility and market conditions. Apply each to the company in the question rather than just listing them.